TDFs to Go

TDFs were “designed to turn inertia from a vice into a virtue,” says Peter Chiappinelli, senior vice-president, investment strategy and asset allocation, with Pyramis Global Advisors, a Fidelity Investments Company. “Don’t do anything; we’ll make the changes for you as you age.”

Plan members want this responsibility out of their hands. According to Fredrik Axsater, head of defined contribution investment strategy with Barclays Global Investors (BGI), when participants are asked if they want to manage their own retirement savings or if they want someone else to do it for them, two-thirds will opt for that someone else. “That’s the target audience for TDFs,” he says.
And TDFs are convenient from an educational standpoint. “In some respects, TDFs are easier to communicate to plan members,” says Oma Sharma, national partner, investment consulting business, with Mercer. “Members do not have to understand the nitty-gritty of how to decide on an appropriate asset mix and which funds to invest in.”

Have TDF, Will Travel
While Canada has only had a taste of the TDF market (the first TDF was introduced here in 2005), the U.S. and U.K. have the full menu of options. BGI’s U.S. target date business has grown over the last two years from roughly $10 billion to about $19 billion in assets—in spite of the market moves. Furthermore, according to a Mercer survey, 86% of default funds in the U.K. were target date-type funds.

TDFs are also gaining in popularity in Canada. According to Benefits Canada’s 2008 Survey of CAP Members, 38% of respondents said their employee retirement savings plan offers TDFs or lifecycle funds. And 66% said they’d be interested in having access to these funds.

Certainly, TDFs have felt the heat in the market meltdown of 2008, but the impact on plan sponsors and plan members has been mixed. “I don’t know whether it’s just recent market activity that’s the impetus for plans looking at [TDFs],” says Duane Green, senior vice- president, institutional investment services, Franklin Templeton Institutional. “Everyone’s been affected within this market downturn, and it highlights the need for target date solutions.”

Colin Ripsman, vice-president with Phillips, Hager & North Investment Management Ltd., feels that this significant market downturn will cause many plan sponsors to re-evaluate their investment lineups. “They might not make changes today, because it’s difficult to make plan changes when investment performance is so poor, but I think it highlights the fact that [plan sponsors] need to offer a more long-term solution.”

Whether or not the downturn spurs plan sponsors to add TDFs to their investment menus, it does affect plan members. “Members tend to focus on short-term performance numbers,” says Ripsman. “When you don’t use TDFs in periods like this, a lot of switching can occur.” And that switching—pulling out of equities, changing to conservative options and potentially missing out on the equity market recovery—could significantly damage members’ long-term results, in the form of lower income replacement levels.

According to a 2008 Employee Benefits Research Institute survey, of the 55- to 65-year-olds polled, more than 40% had 70% or more allocated to equity. “If these people had been using TDFs, yes, they would have been affected by the market decline, but much less so,” says Chiappinelli.

However, even those with TDFs can get burned by poor market performance. “Some of the TDFs had a large equity weighting, and [plan members] were in those funds with only a couple of years to go until retirement, and there were losses of 5% to 15% in 2008,” says Jeffrey Muller, an investment consultant with Buck Consultants. “Those members don’t have a chance to make up the losses.” Chiappinelli argues that while a little criticism is fine, there’s no need to overreact. “A market like this is deserving of some sort of scrutiny—of all product lines. But I hope, in the furor over some capital market losses, that the bigger mission is not lost sight of.”

Choice of Flavours
When deciding on a TDF, elements such as glide path, risk tolerance and active versus passive management need to be scrutinized carefully.

“I think if someone is looking for a target date, it shouldn’t just be for a ‘plain vanilla’ solution,” says Green. That plain vanilla comes to fruition in the glide path—how quickly the fund moves from equities to fixed income and bonds. “While appropriate for the majority of participants, most TDFs don’t allow individuals to differentiate themselves by their specific risk tolerance,” says Shawn Cohen, a senior investment consultant with Hewitt Associates.

Some investment managers feel that individual risk tolerance is too important not to add to the equation. Franklin Templeton, for example, opted to add a target risk overlay to its Canadian LifeSmart Portfolio when it was rolled out in 2007. After members determine their retirement date, they must identify what kind of investor they are: conservative, moderate or growth.

Chiappinelli says this might make sense on paper, but it’s really defeating the purpose of a TDF. “Simplify, simplify, simplify,” he says. “If you ask an individual one question, ‘When do you want to retire?’, they are done. Now you have to get into a risk profile? We’re just repeating the same mistakes that we made for a quarter of a century.”

There’s also the issue of active versus passive management. Axsater says that in the U.S., about two-thirds of new target date assets go to index managers. While he believes that outperforming an index does have its place in investing, indexed TDFs are a better choice for an uninterested employee population. “These participants who go into the default—do you really want to expose [them] to a lot of active management risk?”

Plan sponsors also need to consider the education aspect. “People think that once they’ve selected the fund, they don’t need to do anything else,” says Ross Gilbert, a principal with Morneau Sobeco. “You never stop communicating—even for a target date suite of funds—because plan members do get lazy.” Anna Del Balso, director, strategy and product development, group savings and retirement, with Standard Life, agrees. “[The plan sponsor] still needs to educate members as to the ABCs or the CRTs of investment: contribution, rate of return and time.”

One Piece of the Pie
Another issue with TDFs today is that they do not adequately address the de-accumulation phase. While annuitization is one option for that phase, Chiappinelli says very few North American investors annuitize, for a few reasons. One is that interest rates are cyclical. “If they’re low, a member could lock in to something that won’t be able to keep up with inflation,” he says. Second is the perceived loss of flexibility and control. And finally, “There’s a fear that if you buy an annuity, and you pass away the next year, you lose the bet with the insurance company. Many retirees are hesitant to make that bet.”

Ripsman says TDFs were designed to offer an investing solution for employees during their working careers. However, he believes their effectiveness can be significantly enhanced. “If these funds are going to take their place as the ideal DC investment solution in the marketplace, the time horizons have to extend beyond the target retirement date and really create lifetime options.”
Chiappinelli says it’s a work-in-progress. “The industry is putting [forward] its best thinkers to form a product that has a guarantee of some sort for life but also gives flexibility in trying to deal with the estate planning and legacy issues that have been a big hindrance for straight annuities.”

While TDFs may be a convenient choice for some right now, eventually, the menu will expand so that plan sponsors can order just the right options for their employees.

Brooke Smith is associate editor of Benefits Canada.
brooke.smith@rci.rogers.com

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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the April 2009 edition of BENEFITS CANADA magazine.